What Is a Fixed Income Hedge Fund?

Fixed income arbitrage refers to the arbitrage of debt instruments with fixed income. ^[1]

Fixed income arbitrage

Right!

Fixed income arbitrage refers to the arbitrage of debt instruments with fixed income. ^[1]

Swap spread arbitrage is one of the most popular fixed income arbitrage strategies. The well-known hedge fund Long Term Capital Management (LTCM) once held a huge position in swap interest spreads. Before the incident in 1998, it lost $ 1.5 billion in this strategic position. The biggest loss in a single investment strategy. With the collapse of LTCM, huge positions in swap spreads held by financial predators such as Salomon Smith Barney, Goldman Sachs, Morgan Stanley, Bank of America, Barclays Bank, and DE Shaw were all exposed, and Have suffered huge losses. The huge position of financial predators showed the popularity of the arbitrage strategy at that time.

The swap spread arbitrage strategy consists of two parts called two legs: the first leg, the arbitrageur makes a par swap transaction and receives a fixed coupon rate CMS (Constant Term Swap, Constant Maturity Swap), which pays for the floating London Interbank Offered Rate Lt; the second leg, the arbitrageur shorts out a par value government bond with the same term as the previous swap, and short The proceeds are invested in margin accounts to earn repo rates. The second leg of the cash flow includes a fixed coupon rate CMT for paying par value Treasury bonds and a repurchase rate Rt received from the margin account. Considering the total cash flow of these two legs, the arbitrageur received a fixed annuity SS = CMS-CMT and paid a floating spread St = Lt-Rt. Strictly speaking, swap spread arbitrage is not an arbitrage as defined in textbooks because it has an indirect default risk.

Yield Curve Arbitrage

Yield curve arbitrage is to go long at some points of the yield curve and short at other points. The strategy is usually a "butterfly" transaction. For example, investors make long 5-year government bonds and short 2-year bonds The 10-year Treasury bond makes this investment strategy neutral to the value and slope of the yield term structure. Generally speaking, yield curve arbitrage has many different "taste" strategies, but they also have some common elements. First, an analysis of the yield curve is needed to identify which points are "Rich" and which points are "Cheap"; second, investors build a portfolio and use the wrong valuation found earlier to do Increase some bonds and short others while minimizing the risk of the investment portfolio. Third, hold the investment portfolio until the relative price of the bonds returns and the entire arbitrage transaction converges.

Mortgage-backed securities (MBS) arbitrage strategies consist of two parts, namely, purchasing MBS passthrough securities, and using swaps to hedge their interest rate risk. Pass-through securities are a way to securitize assets. In this way, all principal and interest cash flows (net of service and guarantee fees) in a mortgage loan pool can be transferred to investors in pass-through securities. Bond Market Association statistics show that MBS is the largest fixed income sector in the United States, pass-through securities are the most common mortgage-related products, and mortgage arbitrage strategies are also commonly used by hedge funds. The main risk of MBS passing securities is the risk of early repayment, because the owner can repay its mortgage loan in advance, which makes the cash flow of passing securities uncertain.

For hedge funds engaged in fixed income investment, volatility arbitrage plays an important role. For example, before the crisis in 1998, LTCM lost more than $ 1.3 billion in volatility arbitrage positions. The simplest way to implement a volatility arbitrage strategy is to sell options and then perform a delta-hedge on the underlying asset. If the implied volatility at that time is higher than the subsequent actual volatility, then selling options will generate excess returns and investors will profit from it.

Capital Structure Arbitrage

Capital structure arbitrage is sometimes called credit arbitrage, which refers to a type of fixed income trading strategy that uses the mispricing relationship between the company's liabilities and other securities (such as equity). With the exponential growth of credit default swaps (CDS) in the past decade, this strategy has become more and more popular with proprietary dealers and investment banks, and more and more Of hedge funds are involved.

The above introduces several fixed income arbitrage strategies commonly used in the international market. With the development of the fixed income market including cash bonds and derivatives, domestic fixed income strategies and related products will be greatly enriched. Compared with overseas mature markets, its development space is huge, and the challenges it faces are also great. Among them, talent is the most important. These complex investment strategies require a large amount of "intellectual capital" from design to implementation. Foreign countries Research shows that the strategy of investing more knowledge capital will produce more significant excess returns, which also proves that knowledge can generate additional returns in the financial field, and investment in this area is very valuable.